Although the central bank claims that its monetary policy "targets" positive real interest rates that takes into account inflation, many in the financial market view the ground realities differently. And small savers complain that they have suffered from negative return on bank deposits for a long time.

Voicing the market sentiments, a leading bank's treasury official says, "inflation has ceased to be a benchmark for reaching the real interest rate level." The creation of liquidity is too rapid. The market and the banks are awash with liquidity. And the economists have changed their theories.

The spectre of inflation is haunting financial markets, worldwide. In Pakistan, for households of different income groups bracketed together, sensitive price inflation measured by increases in prices of 53 essential items rose by annualised 12 per cent during the week ending June 10. In May, inflation measured by Consumer Price Index showed a big increase of 7.13 per cent as compared to May 2003.

But central banks tend to focus on core inflation that excludes energy and foodgrain prices and represents policy (fiscal, monetary and exchange rate) induced inflation. For 11 months, the core inflation rate, according to SBP was 3.34 per cent.

The State Bank Governor, Dr Ishrat Husain, told Dow Jones news service that his "response" to rising inflation would be "very measured"... in the light of" evidence which accumulates over time." The central bank wants to provide cheap credit to the private sector to fuel economic growth while at the same time containing inflation.

To quote foreign economic journals, the sharp rise in inflation worldwide has become a source of worry for the financial markets.

The 12-month rate for American consumer price inflation was 3.1 per cent in May against 1.7 per cent in February. Though the rise in inflation rate was much sharper than expected, Fed Chairman Alan Greenspan was quoted as saying: "Inflationary pressures are not likely to be a serious concern". Earlier, Greenspan remained silent when the Bush Administrative turned huge budget surplus into massive deficits by tax cuts to bail out corporates in fiscal distress.

Since the start of the year, the US consumer prices have risen at the annualised rate of 5.1 per cent. In Euro area, inflation rate is 2.5 per cent against a ceiling of 2 per cent fixed by European Central Bank. In China it is 4.4 per cent.

Inflation erodes the real value of money, makes things complicated for the firms, households and savers,say economists.

Eminent social scientist Joseph Stiglitz believes that price is central to the confidence of the economy. Prices serve as signals guiding the allocation of resources. If the prices are basically random based on irrational whims of market speculators, then investor go helter-skelter.

Some adjustments in interest rates have been made by the State Bank in response to creeping inflation, officially estimated at 4.5-4.6 per cent for current fiscal. Export finance has been cut by 0.5 per cent to 3.5 per cent and a similar raise is not ruled out by the market. From February this year, treasury bill rates have started rising.

The six-month T/bills rate is up from 1.2 per cent to over 2 per cent. The weighted average lending rate has moved up from 4.69 per cent in end March to 5.09 per cent by end April. But the discount rate, cut by a sharp 1.5 per cent in November 2002 to 7.5 per cent, remains unchanged.

Seasoned bankers see a creeping increase in the interest rates between O.5 to 1 per cent over time.They do not see a big rise with banks and market awash with money. And a noted official economist reckons" good enough" rate of consumer price inflation should be 1-2 per cent lower than the economic growth rate. A variety of factors have combined to fuel inflation including economic growth on the back of domestic demand, costlier imports and foodgrain shortages.

The import unit value index has gone up by 13 per cent. These include prices of crude and petroleum products, palm oil, fertilizer, medicine products and iron and steel. In the domestic market, prices of wheat, flour, rice, meat, edible oil, onion shot up for a variety of reasons.

Imports are being liberalized by tariff cuts. Since inflation is picking up worldwide, the economy would be hit by imported inflation. Imports create jobs for labour in foreign countries with negative contribution to the Gross Domestic Product.

The cumulative trade deficit for April and May amounted to over one billion dollars and coupled with debt service, it has been impacting on the exchange rate. In two months, the rupee has lost 64 paisa of its value against the dollar.

During July-March 2004, the real effective exchange rate depreciated by 3.3 per cent, losing its value against euro, yen, British pound and Australian dollar. A depreciating rupee means that imported cost of goods and services go up further, impacting adversely on cost of investment that has been encouraged through stable exchange rate and low interest rates. Financial analysts however complain that industry has not shown dynamism and much of the opportunity offered by cheap and abundant money has been lost for short-term gains.

If there are no positive yields on credit, financial analysts assert money will find alternative sources of investment. The US has been printing dollars to meet its daily needs of $1.7- 1.8 billion. How long can Americans go on printing dollars,financial analysts ask and add it would mean more inflation. US treasury rates have already started going up.

The underlying issue in bank lending is the real value of money/positive interest yields. If the return on deposits is negative, savings are discouraged.Household savings provide banks with bulk of the deposits which is ploughed into investment. But, the depositors get a negative return on their savings and corporates borrow at rates lower than the inflation rate. Big borrowers get loans at lowest rates because of the volume of credit and the business they offer to the banks.

Lending rates to SMEs are much higher because they are labelled by lenders as a risky business(though proved otherwise) and transactions are of smaller volumes. Micro-finance to the poor are the costliest. So the money is priced by accounting for risks,costs, demand and supply. And the lending rates vary from 4 to 20 per cent. The rates differ from bank to bank and from individual to individual borrower. Sometimes ago, the treasury bill rates were at 16-17 and now they are at 2 per cent.

The Zarai Taraqiati Bank has been asked by President Musharraf to reduce the interest rates on all types of agricultural loans to nine per cent. Bank officials say that they offer farm loans at nine per cent,( after a three per cent discount), for borrowers who pay on time. And if the borrower applies for a fresh loan, it is extended at eight per cent. These rates are also applicable to micro-finance. The bank has shown the way as to how the risk factor is taken care though lower mark-up on timely payment. It should be followed by other lending institutions.

But one wonders what determines the real value of money and the real interest rates.